How to Prepare for a Recession

It’s hard to escape the discussions in the news of an impending recession. Banks are saddled with billions in losses from bad loans they made forcing them to cut back on lending which in turn slows economic growth. Consumer’s balance sheets are also in horrible shape. We went from a national savings rate of 10% in the eighties to a negative savings rate in 2007. Warren Buffett is on record saying that we may see a longer and more severe recession than most economists are predicting.

It’s not fun to be writing about a potential recession. Recessions bring with them a higher probability of job loss, and more difficulty in finding new jobs. Economists argue about the exact definition of a recession but an old joke goes that a recession is when your neighbor loses his job and a depression is when you lose your job. This is the biggest threat of a recession, losing ones job. Job loss isn’t the only problem in recessions, often companies cut back on salary increases, and new jobs being created are lower paying with less benefits. There’s a story President Clinton used to tell where he was at dinner talking about the four million new jobs his administration helped create and a waiter turned to him and said he had three of those new jobs.

I recently read an article that in Britain the average person only has savings to support themselves for 52 days without an income, and that 36% only had savings to support themselves for 11 days if they lost their jobs. I can’t imagine the numbers are much better here in the United States. It’s imperative for people to start preparing for a recession by increasing their savings. We may not enter a recession, and if we do it may not be that severe but it is much better to be prepared for the worst than do nothing but hope for the best.

Here are several ways people can start preparing for a recession:

Before we do any contingency planning it’s important to understand exactly where we currently stand financially. To do this we need to get a handle on how much is coming in, how much is going out, and how much assets and liabilities we have.

Budgeting: The first step is to get a handle on where every penny you are currently spending is going. If you haven’t already you need to create a budget that lists every expense: mortgage, food, insurance, clothes, entertainment. No expense is too small to be left out. Be sure to include expenses that are billed on an irregular basis like car insurance, or winter heating oil so they’re not left out.

Balance Sheet: Next prepare a simple balance sheet listing all the assets you have: cash, securities, home equity, retirement savings. Then list all your liabilities such as credit card balances, mortgage, home equity loans, car loans, and any other liabilities you might have. Be sure to list the interest rate you are being charged on each loan.

Emergency Budget: Create an emergency budget you can immediately put in place if a job loss or pay cut occurs. An emergency budget is a bare bones budget that cuts out most discretionary items such as dining out or entertainment.

Where do you Stand: Given your current savings and monthly budget how many days would you be able to support your family if you lost your job? The typical recommendation for an emergency fund is 3-6 months. This is primarily based on the time it would take to find a new job. Keep in mind that in recessions, it becomes much tougher to find a new job because business are cutting jobs and the number of people looking for jobs is growing. The average job search takes longer during a recession which means you will need an emergency fund that lasts longer.

Emergency Fund: If you find that you have less then three months of emergency savings and you don’t have any other liquid assets you can fall back on you need to start adding to your emergency fund. See our recent post on How to Create an Emergency Fund for more information and tips on this topic.

Big Discretionary Items: Put off any purchases of big discretionary items such as plasma TVs or vacations. Make your top priority increasing your emergency fund.

Look for areas to cut: Go back through your budget and look for areas to cut. Maybe you’re able to cut money out of your budget by not dining out, or cut your food budget by using coupons or buying generic brands. Find ways to cut and channel the savings into your emergency fund.

Sell Unwanted Items: One way to bulk up your emergency fund is to sell unused or unwanted items in a garage sale or on ebay or craigslist.

Some other things to keep in mind:

Liquidity: You emergency fund should be liquid and always at the ready. Don’t have your emergency funds in a one year CD where there are penalties for early withdrawal. You should have your funds in a high yield savings account that is FDIC insured.

Fresh Resume: Always have an updated resume and cover letter ready to go in case you’re laid off. You want to be able to start your job search on day one to minimize the time you’re without a job.

COBRA: You should read up on COBRA medical insurance benefits. COBRA ensures that employees can still receive the company’s same insurance coverage in the event they are laid off for a certain period of time. You have a certain window of time from your termination by which you must register for COBRA. The unfortunate thing about COBRA is that you are responsible for paying the employer as well as the employee portion of the cost. This additional expense can be a shock to people because they don’t realize how much money their company is paying in terms of their medical coverage. Be sure to factor this cost into your emergency budget if you think you might be using COBRA coverage.

Dental Insurance: If your employer offers dental insurance and you feel your job may be in jeopardy be sure to take advantage of the benefit sooner rather than later. Schedule all the family members eligible on the policy for their annual check-up or any other dental services they may require that are covered by the policy. Take full advantage of the benefit while it’s still there.

Disability Insurance: You may want to look into disability insurance now while you have a job so that the disability benefit is based on your current salary.

Company Stock: If a significant portion of your net worth is tied up in stock in your company you may want to talk with a financial adviser about diversification. You are already heavily invested in your company just by the fact that you derive your income from the company. If your company starts layoffs chances are its because business is not good and that’s not good for stock prices. You don’t want too many of your financial eggs in one basket.

A recession and the prospect of losing one’s job are not delightful subjects but having plans in place and a nice, plump, emergency fund will limit the stress and impact should you lose your job or get squeezed financially.